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A stable financial system plays an important role in the social and economic development of societies. Financial crises took place in different parts of the world but their impact was not only limited to that particular country but we have seen ripple effect in the form of higher levels of unemployment, slowdown of global economy and increased financial instability. The implications of recent global financial crisis have national, regional and international relevance.

A financial system is composed of different elements such as financial intermediaries commonly known as banks, non-banking institutions and financial markets. However, the contemporary financial system has broader perspective and a wide range of entities are part of it like such as banks, non-bank financial institutes, asset management companies, insurance companies, credit rating agencies, mutual funds, stock market, central banks and different credit instructions. The main purpose of a financial intermediary is to provide excessive savings to investors so that it could be invested in economy which rotates wheels of an economy. Investments create jobs which improve the living standard of individuals and society. There is a direct relationship between financial stability and intermediaries. The fundamental question here is what is the proper definition of financial stability and why is it so important nowadays? Financial stability is highly important because in case of instability, whole financial and economic system cannot function properly. This situation leads to a trouble for all participants. For instance, financial institutions will be not in a position to address the financial needs of individuals and businesses. This could be non-payments and on the other hand, businesses cannot borrow, hence economic activity becomes low and whole financial system comes to halt. Financial system is considered as a backbone of a well-functioning economy because it provides much needed funding. For instance, companies cannot buy raw materials from other countries without guarantees of banks. If banks have liquidity shortages, then they cannot finance consumption needs of individuals. There is no comprehensive definition of financial stability and several researchers have attempted to define it in the context of financial stability and instability such as Mishkin states that “financial instability occurs when shocks to the financial system interfere with information flow so that the financial system can no longer do its job of channelling funds to those with productive investment opportunities.”

Financial instability is caused due to systemic risk and financial crises. A systemic risk is a situation when a financial system is poised with a major threat and it could not normally function. Financial crisis can be defined as “a major collapse of the financial system, entailing inability to provide payments services or to allocate credit to productive investment opportunities.” In case of a major collapse of a financial system, stability of an overall economy and related financial institutions and individuals is threatened.

Financial stability is important for the global financial system. This world has seen a number of financial crises since the Great Depression of 1929. However, recent financial crisis of 2008-09 was the worst since the Great Depression. Many governments around the world had to save financial institutions from further negative consequences by providing bailout packages. The main reasons of the financial crisis were a lack of strong financial and banking regulations, excessive use of financial derivatives, inadequate response from the market regulators and ignoring of early signs of financial crisis. It is the duty of regulators and governments to provide stable financial environment in which economies can flourish.

Muhammad Ashfaq is CEO at Amanah Institute of Islamic Finance and Economics and author of the book “Islamic Banking and Finance in Europe: The Case of Germany and United Kingdom”